For investors looking for a balance of security, liquidity and yield, covered bonds are a good place to look in the fixed-income market. Combining the creditworthiness of established financial institutions with additional security provided by a pool of underlying assets, they offer an alternative to conventional corporate or government bonds. Despite their many benefits, however, investors should ensure they understand the risks associated with the instruments before acting.
What are Covered Bonds?
Covered bonds are debt instruments issued by banks and building societies to raise medium- to long-term funding. But unlike conventional bonds, covered bonds are secured against a pool of high-quality assets, most commonly residential mortgages.
One defining feature is ‘dual recourse’ protection, which gives investors two sources of repayment. First and foremost, the issuing institution is responsible for making payments of interest and principal, as would be for conventional bonds. However, the second source is where they differ from conventional bonds in that if the issuer defaults, bondholders have a preferential claim over the bond’s underlying assets, known as the ‘cover pool’.
The cover pool is held separately from the bond issuer's other assets, and the value of the pool generally exceeds the outstanding value of the covered bonds, providing additional protection through over-collateralisation. Assets within the pool must be replaced during the life of the bond to maintain the required level of credit quality and coverage.
In the UK, regulated covered bonds operate under the supervision of the Financial Conduct Authority (FCA) and many major UK banks and building societies participate in this market.
What are the Benefits for Investors?
High Credit Quality: One main benefit of covered bonds is their strong credit quality. The combination of issuer obligations, high-quality collateral, regulatory oversight and over-collateralisation provides investors with significant protection against potential losses.
Because of this, covered bonds typically hold higher credit ratings than equivalent senior unsecured debt issued by the same institution. As a result, many covered bond programmes are rated AAA. This enhanced security makes them attractive to investors prioritising capital preservation.
Bail-in Exempt: In the event that investors are required to recapitalise a failing bank, as a secured debt obligation, covered bonds are exempt from bail-in under the Bank Recovery and Resolution Directive.
Attractive Risk-Adjusted Yields: Covered bonds provide a good balance between security and income. While their additional protections can result in lower yields than similar unsecured bank debt, they can offer a yield premium over government bonds of similar maturity. This allows investors to boost portfolio returns without taking on the additional credit risk associated with unsecured corporate or bank debt.
The sterling market offers a range of maturities, allowing investors to select bonds that align with their cash flow requirements and investment horizons. Bonds with both fixed and floating rates are available, allowing investors to also chose based on their requirements for income/interest rate certainty or flexibility, and their risk tolerance for potential movements in price.
The yields will vary based on factors such as the issuer, credit rating, maturity date, market conditions as well as investor demand. Reviewing the spread over a comparable security, such as a government bond, is an important check when determining the covered bond’s relative value.
Liquidity and Market Access: Covered bonds benefit from a well-established institutional investor base, particularly across Europe, where the market is large and well developed. Large issues from recognised institutions can also offer good secondary-market liquidity and therefore allow investors to sell before maturity if needed. Their strong credit characteristics and eligibility for certain central bank collateral arrangements can also support market demand.
But liquidity varies significantly across individual bonds. Larger, frequently traded issues will generally offer better market access than smaller or less established programmes, and covered bonds should not be regarded as equivalent to cash or short-term deposits.
What are the Risks and Considerations?
Despite their strong credit profile, covered bonds are not risk-free.
Credit and Collateral Risk: While dual recourse reduces potential losses, investors are exposed to deterioration in the issuer's financial position and the quality of the underlying assets. Severe mortgage defaults, falling property values or insufficient collateral could compromise repayment if the issuer has insufficient capital or unsecured liabilities to absorb the losses.
Market/Price Risk: Like other fixed-rate securities, the prices of fixed rate covered bonds generally fall when market yields rise. Therefore, investors selling before maturity could potentially realise capital losses, particularly on longer-dated bonds.
Interest Rate Risk: Interest rates on covered bonds with floating rates move with respect to a reference rate (e.g. SONIA). In a rising rate environment this would mean the coupon payments automatically adjust upwards, benefitting bondholders, but floating rates introduce uncertainty into future income payments which may be undesirable for some investors.
Liquidity Risk: Secondary-market liquidity cannot be guaranteed and during periods of financial stress, trading activity could decline and bid-offer spreads widen, increasing the potential cost of selling investments.
Market and Spread Risk: Bond values can fluctuate as credit spreads change, even where the issuer remains financially sound. Changes in investor sentiment, banking-sector conditions or the supply of new issuance can affect market prices.
Structural and Legal Risk: Protections depend on the governing legal framework and specific covered bond programme arrangements. Investors should consider differences between jurisdictions, collateral eligibility, over-collateralisation requirements and the potential for repayment delays following issuer insolvency.
Nevertheless, covered bonds present a lower risk profile than many other investment options including bank deposits and corporate bonds.
Should I Invest?
Overall, covered bonds enable investors to diversify their portfolios while maintaining a strong focus on security and returns. While their ultimate suitability will depend on each investor’s strategy, approved instruments, credit criteria, maturity limits and liquidity requirements, they generally offer a combination of strong credit quality, potential yield enhancement alongside access to established and liquid secondary markets.
While their additional protections distinguish them from conventional unsecured bank debt, careful selection, diversification and ongoing monitoring is key to ensuring they contribute effectively to an investment portfolio.
Investors should also undertake appropriate due diligence, considering both the issuer's creditworthiness and the characteristics of the specific covered bond programme.
At Arlingclose, we have been advising clients on covered bonds for many years, and we continue to advocate the benefits they can bring to portfolios. Please get in touch with us at info@arlingclose.com if you would like to find out more about how we could help bring covered bonds into your portfolio.
